The S&P 500 and the Nasdaq are both drowning in red ink and Bill Lippman is having a ball.


Manager: Bill Lippman

Funds: Franklin Balance Sheet Investment, Franklin MicroCap Value, Franklin Value, Franklin Rising Dividends and Franklin Large Cap Value*

Combined Assets: $2.2 billion

Sources: Franklin and Morningstar.
*Funds are run by a team of managers.

Lippman, a practicing value investor for forty years, says he and his bargain-hunting colleagues are in a bull market. From their Fort Lee, N.J. offices, he and his colleagues run five funds for West Coast-based

Franklin Templeton

, calmly scouring the market for solid companies they think are selling for less than they're worth. Growth and tech stocks, which lorded over the market in 1998 and 1999, are in bear market territory, and Lippman says he and his colleagues are scooping up bargains left and right.

It's easy to see why he's smiling. His

(FRBSX) - Get Franklin Mutual US Value A Report

Franklin Balance Sheet Investment fund tops its small-cap value peers over the past one-, three-, five- and 10-year periods, according to

Morningstar

. And all five of the value funds he and his colleagues run are trouncing the

S&P 500

and beating their peers over the past year.

He's kindly taken time to talk large-caps with us, and if we can all agree that valuations matter, then we can all agree that a valuation-obsessed fellow like Bill is a good person to talk to. How does he find undervalued stocks? Does he think fallen tech angels like

Cisco Systems

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or

Intel

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are cheap? And what stocks would he buy today with a five-year time horizon? To find the answers, read on.

1. How do you find stocks that are values, not just cheap?

Lippman:

We do a lot of screening. Our first cut is a company's price-to-earnings or price-to-cash-flow

multiple. There's no fixed number to attract us, but generally speaking we won't look at a company unless its valuations are cheap relative to its peers and its own historical range. A stock that has dropped 70% isn't cheap to us. It has to be cheap based on its normal P/E multiple over the past 10 years. We try to buy in at the lower half of a company's 10-year range. It's also very rare that we'd pay above a market P/E for a stock.

Value Proving Its, Well, Value
The value investing style has gotten back on its feet after trailing growth in the second half of the 1990s

Source: Morningstar. Annualized returns thorough April 12.

There's qualitative analysis too, right?

Lippman:

Yes, after a screen, we ask if it's a good business. Do we understand it? Are we comfortable with the management, and does management own a significant share of the company? In large-cap companies, management often doesn't own a significant percentage of shares because there are so many shares out there, but we want to know that they own shares. We want managers to be competent, honest and shareholder-friendly.

We also want revenues and earnings to be increasing. There has to be a strong balance sheet too. When you're a value investor you often have to wait around a while, and you need to make sure the company will be there. That's why we care about the balance sheet.

2. But for companies to be cheap and have these attributes, things can't be sunny, right?

Lippman:

In every value stock you have a cloud hanging over the company. That's why it's a value.

In small-caps, the cloud is often that no analysts cover it and it's unknown. In large-caps, the cloud could be something we see as temporary, lasting six to nine months, or it could be a bigger problem.

For example, the auto industry had a great year last year and many thought they were due for a downturn and auto stocks reflected that. Now the numbers look good for this year and they're going up. We bought

Ford

(F) - Get Ford Motor Company Report

in June of last year

when the

Franklin Large-Cap Value

fund launched and since then it's up 9%. The predictions then were that we've seen the best year, so don't expect that again. But it's up 23% just from the start of this year.

3. Once you buy a stock, do you set a price target? And how long do you plan to hold shares once you buy them?

Lippman:

We do set a price target for every stock and my time horizon is long. We are long-term holders and our funds' turnover rates are always below 30%

meaning less than 30% of the fund's portfolio changes in a given year. We buy a company with the idea of holding it for five years.

When we buy a stock we set a price target of where we think it could go in 12 months. If a company is earning $2 a share and it usually sells at 15 times its earnings, we use $30 as a target. We're not slaves to a target, but it requires a decision as we get to it.

A Solid Balancing Act
Lippman's Balance Sheet Investment fund has stayed ahead of its peers over time.

Source: Morningstar. Annualized returns thorough April 12.

4. What sectors and stocks are looking oversold to you today?

Lippman:

We don't really look at sectors. We look at companies bottom-up and we're not big on themes. But having said that, we have 31% of the Large-Cap Value fund in financial stocks like banks, thrifts, insurers or loan companies. We own

Allstate

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, a big brand name company. We bought it in June for the Large Cap Value fund. They got a new CEO a couple of years ago and he and his colleagues have run the company really well.

We got the stock cheap because financial companies are often viewed as interest rate plays. When rates go up, they go down. I don't think that's reasonable, but that's what the market does. When rates were going up last year, financial stocks fell from favor and we started buying companies like Allstate. The reason the market didn't like it was interest rates. We knew rates might keep going up, but we knew they'd come down at some point and the company would do well on its merits. So we bought it.

Then we also like

American General

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, which has also been an acquisition target.

Prudential Life

of Great Britain made an offer and AIG made a better offer recently.

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We also have sizable positions in energy stocks. We think energy prices will stay high. The price of oil is settling at $23 to $25 a barrel, so drilling companies should do well for a while. It's a cyclical business, but we think we're in the right part of the cycle.

In energy we own shares of

Anadarko Petroleum

(APC) - Get Anadarko Petroleum Corporation Report

,

Phillips Petroleum

(P)

and

Burlington Resources

(BR) - Get Broadridge Financial Solutions, Inc. Report

.

5. Every value investor can tell you that they've bought stocks that looked cheap, only to see them get cheaper. What sectors and stocks are looking like value traps to you today?

Lippman:

These situations are universal because no one buys at the bottom. We went through this with the energy stocks initially. A barrel of oil usually sells at $20 per barrel. When it got to $15 per barrel, we bought some drilling stocks and then the price of oil fell to $11 a barrel. Was that a value trap? Maybe, but I just think of that as being early. We're almost always early.

I think the real trap today is technology stocks. A company falls 70% and you think it's so cheap, but you could buy it and see it fall much further. Keep in mind that many of these sold at 100 times earnings, and often 100 times revenue, and that's still expensive even when they're way down. Even at 50 times earnings, these aren't value stocks. We looked at Cisco and Intel and they're just not cheap enough for us yet.

6. Is this year vindication, after large-cap growth in general and tech stocks in particular lorded over the market in the second-half of the 1990s?

Lippman:

It's more fun. Life is fun again. We stuck to our philosophy but it was very hard. In 1998 and 1999 it was a long bear market for value funds. At parties people would say, "You must be thrilled with the market," but I would slink into a corner. We kept doing what we do. Now we've come out of a two-year bear market where money was coming out of the funds and we had to sell stocks we wanted to buy. That turning point started last March

when the Nasdaq Composite peaked, but I think this is just the beginning. The two-year bear market knocked prices in our areas to levels that were just too low.

I think in the last two years intelligent investors capitulated to the momentum flow. They said, Here's a stock trading at 60 times earnings and it shouldn't, but I'll buy it because it's going up. They jumped on that gravy train and they made a lot of money. Of course, it ended up biting them. It was a good way to make money for a while even if it wasn't sensible.

Then people said there are these great mundane companies out there that make valves and machinery, but they capitulated and sold out of them because they weren't going anywhere.

Now we're seeing the reverse. They can't get out of tech fast enough, and they're coming back to the idea of buying good companies at good prices, which is what we're supposed to do. I think this is here for a good long while.

7. Are you seeing positive in-flows now and do you think continued out-flows from growth funds could hurt tech stocks just like they hurt value stocks in 1998 and 1999?

Lippman:

Those outflows in '98 and '99 certainly were a drag on value stocks. We were driving our own stocks' prices down. We had redemptions through most of 1998 and all of 1999. There was some money flowing in but there were redemptions. Even if we didn't have big redemptions, our competitors did. We would have loved to buy what they were selling but we couldn't. And we were selling, too. It had a negative impact on stocks that were already beaten down.

Over the last six months we've had sizable in-flows, but I don't think we're pushing up our own prices. In terms of growth and tech fund redemptions, I think most of the big companies like Cisco and Intel won't be hurt too badly. In small stocks it might be a problem because they're less liquid, but not in big, good companies. I don't think it will be the same.

It's funny, so far holders of growth stocks seem to be saying, "Yes I'm down, but I'll wait." So I doubt that redemptions will hit them too hard, not yet anyway.

8. Do you favor an even split between growth and value investments for a diversified portfolio?

Lippman:

I do think asset allocation is the right way to go. Among stocks, I'd say put part in growth, value and international. I'd say split the split there might be 40%/40%/20%.

I think it's less worrisome to own both growth and value styles, not just one. You want to be in the right style when it has the wind at its back, but that's hard to do consistently.

9. Every value investor has an opinion on Phillip Morris (MO) - Get Altria Group Inc Report -- what's yours?

Lippman:

I think it's great. Unfortunately, it's selling cancer but it's really well-run and has produced great results. We own it in the Large Cap Value fund and we think it's a value because it's subject to lawsuits daily. You couldn't buy it at these prices without that cloud. A problem is that a lot of institutions won't buy it because of the business it's in. From June 1 of last year it's up 56%. It's still not expensive, selling at 11 times this year's estimate with a 4.5% dividend.

We've owned it for a long, long time in other funds. The only one we have it in right now is Large Cap Value. I think the stock will do well for the next couple of years. It's not as cheap as it was -- we bought it at 7.5 times with a dividend yield of 6%. They are in the food business and they're going to spin off

Kraft

. It's not a screaming buy today but I think you'd do well over five years if you bought it today.

A Real Roller Coaster
Philip Morris shares have had a bumpy, but often profitable ride.

Source: Morningstar

10. If you had to choose three stocks to own for the next five years, which would they be and why?

Lippman:

One that comes to mind is

Washington Mutual

(WM) - Get Waste Management, Inc. Report

, the largest thrift out on the West Coast. That's subject to the ups and downs of interest rates. It's done well because rates are going down. It's got a P/E of 12 and a nice above-market yield. I think if you put this away and looked at it five years from now it would be higher. That said, it will fluctuate with rates.

There's also

Family Dollar

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l. They have about 3,500 small discount stores. They are a very small version of

Wal-Mart

. They have small stores in small towns with similar discounts. The company has compounded earnings at 20 times a year for five years. It's a fairly high P/E for our taste, 20 times this year's earnings, 17 times next earnings. But it's well-run, it has no debt and it's expanding. It's a big position in several of our funds.

I also wouldn't object to Philip Morris or even Ford. Ford pays a nice dividend of over 4%, has a lot of cash and is broadening its product line through acquisitions.

Speaking of dividends, should individual investors be looking for dividend-paying stocks when they're trolling for long-term investments?

Lippman:

Yes, but it's not a great first cut to look for companies paying high dividends. That will give you a lot of utilities. It's best to look for companies that are increasing their dividends each year. I don't think the goal is to start with high dividends, but dividend growth. Philip Morris has grown its dividend year after year.

I think it's important for companies to pay a dividend. If a company is raising their dividend, it shows two things: The company can do it and they wish to do it. It shows that they're financially healthy and thinking of their shareholders.

Diebold

(DBD) - Get Diebold Nixdorf Incorporated Report

a maker of ATMs, among other automated processing machines has raised its dividend for 43 straight years; that's a company you can hold for a while.